Buffett’s Bet

There is a dispute over how you should be investing your money and Warren Buffett has lined himself up as the antagonist of hedge fund managers.

Before jumping into the fight, a quick primer on active and passive investing: Active funds are actively managed (and clearly creatively named) funds in which the fund manager tries to pick investments that will perform better than the market. Passive funds (or index funds) are funds that simply try to match an index rather than beat it. For example, instead of trying to pick the companies that will outperform the market, a passive S&P 500 index fund will purchase every company in the S&P 500.

Warren Buffett, the third richest man in the world, is a big believer in passive investing for the average investor. While he takes an active role in managing the investments of his company, Berkshire Hathaway, he believes that the vast majority of people are better off placing their money in low fee index funds and investing passively.

Active fund managers have tended to disagree with him. They argue that by investing with a hedge fund or an actively managed mutual fund, average investors can get an increased rate of return. Buffett’s response is that any additional return that the funds manage to generate is more than eaten up by the extra fees that active managers charge their investors.

Buffett states:

“A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors. Investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds.”

This dispute is at the center of a bet that Warren Buffett entered into with Protege Partners LLC in 2008. Buffett issued an open $1 million bet (with the million dollars going to a charity of the winner’s choice) that no hedge fund manager could beat a simple S&P 500 index fund over a decade after accounting for fees. Protege was the only firm to take up the challenge.

Buffett put his money into VFIAX, Vanguard’s S&P 500 fund. (Personally I prefer VTSAX, which includes a wider slice of the market, but either works for the purpose of showing the benefits of passive index investing. I’m also not a billionaire, so take that for what it’s worth.) Protege put their money into undisclosed actively managed hedge funds.

The bet began on January 1, 2008. You may recall that 2008 was not the greatest year for the stock market, and both sides immediately dropped significantly. Buffet fell 37% in the first year, while Protege fell 23.9%, taking an early lead. The S&P then went on to outperform Protege every year from 2009 through 2014. While Protege slightly outperformed the S&P in 2015 (1.7% gain vs. the S&P’s 1.36% return), it was not nearly enough to make a dent in the sizable lead that Buffett had taken.

As of the close of 2015, Buffett’s S&P 500 investment was up 65.7%, while Protege’s investment was up 21.9%. While the bet isn’t over until December 31, 2017, the market crash required for Protege to regain the lead would need to be massive. (It is nice to note that Protege is not rooting for the market conditions that would allow it a chance to win.)

So what can we, as average investors, take away from all of this?

First, passive index investing works. Buffett was able to set aside money in VFIAX (it takes less than five minutes to do so), ignore it for eight years, and have 65.7% more money. Five minutes of work, eight years of doing nothing, 65.7% profit. Not too shabby.

Second, and a bit more nuanced, is recognizing the relative benefits of actively managed funds and passively managed funds. Protege beat the S&P two out of the eight years of the bet. Those two years were the S&P’s two worst years during the bet. Basically, the actively managed funds’ lows weren’t as low, but their highs weren’t as high. Protege’s returns were less volatile than the S&P index.

While this may seem like a good thing, that lack of volatility came with a great cost over time. By the end of the eighth year, the S&P had cumulatively outperformed Protege by just about 44 percentage points. That’s a lot of money. And it would have been even more money if the parties had been continuing to contribute to the funds over time like a normal investor would have. Buffett took three more years to catch up to Protege after the 2008 crash. A normal investor would have been continuously buying at the bottom of the market and would have made a ton of money by buying when stocks were on sale in 2008. Peter Seiles, the man behind the bet for Protege, pointed out that from 2009 through 2014, “the S&P 500 returned 159%, in comparison to the 57% return of the fund of funds.”

So while actively managed funds can certainly outperform index funds over short periods of time, especially in bad years, passively managed index funds are your best bet in the long term.

The solution, then, is to get started early so that you have time to wait out the dips and drops. Go set up automatic contributions to your 401k and/or your IRA (or set one up if you don’t have one yet). If you’re already maxing your retirement accounts, then sign up for an individual brokerage account and set up automatic investing there.

Investing doesn’t need to be difficult. All you need is to maximize your time in the market. So follow Warren Buffett’s advice and start investing in passive index funds to grow your money with minimal effort.

3 thoughts on “Buffett’s Bet”

  1. Pretty impressive performance for Buffett and a good bet to win (even though it isn’t quite over).

    I think it’s interesting you noted the lack of volatility led to lower returns. So I presume that means protege bet on a conservative portfolio? I think this goes to show that volatility doesn’t need to be feared, especially for long term investors!

    Thanks for the post!

    1. Protege has not disclosed what funds they are actually invested in, but they certainly have performed more conservatively than the markets as a whole, so I think that is a safe guess.

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